Monday, October 26, 2015

A Call to Action re: The DOL Conflict of Interest Rule

As the U.S. Department of Labor seeks to pour through all of the comment letters received, in an attempt to finalize its "Conflicts of Interest" rule by early 2016 (with a later effective date), Wall Street and the insurance companies are pouring hundreds of millions of dollars at lobbying efforts, and misleading television ads, to stop this very important development. Permit me to share some stories, and some thoughts:

The "Suitability" of a Replacement Annuity. Ms. Grange (not her real name) was a 74-year old retiree. In her IRA account - her sole source of funding for her retirement needs other than her social security check - she had previously been sold a variable annuity. She desired to "annuitize" this investment - i.e., turn it into a lifetime income stream. She went back to her broker (i.e., registered representative of a broker-dealer firm, also registered as an insurance agent). Her broker advised her to roll it into a new immediate annuity, to generate the income stream. Later Ms. Grange came to see me. I discerned that the effective rate of return, assuming she lived to age 95, was only 1%. But her prior annuity would have provided a rate of return of 4.5%, with the same assumption. And, a little analysis would have revealed that her rate of return would be even high had she waited until age 75 to annuitize her prior annuity, under the annuity contract's provisions. Both annuities were from strong insurance companies. In essence, Ms. Grange was getting a lesser monthly check from the new annuity than from the one she already had. The new annuity had no benefit to her. Why did the broker do this? To generate a new commission for himself. Plain and simple. I had a securities law attorney analyze the case, to see if a complaint in arbitration made sense. "Little chance of recovery," he replied. The new investment was "suitable." The broker had no fiduciary duty to the client.

The Plan Sponsor: Hung Out to Dry. An employer established a 401(k) plan for his employees. Not well-versed in the intricacies of such plans, he sought advice from a "retirement plan consulting firm." The firm, not a fiduciary (despite their use of the term "consultant") recommended a selection of high-cost funds for the plan, from their affiliated insurance company. Years later the employer (plan sponsor) was sued by his employees for breach of the plan sponsor's fiduciary duty of due care. The employees prevailed, and the plan sponsor / employer was forced to come up with a huge sum to reimburse the plan (in addition to paying substantial legal fees). What happened to the retirement plan consultant? Nothing! Because the "consultant" was not a fiduciary, and the investments recommended - while high-cost - were "suitable." Why had such high-cost funds been recommended? Because they paid the consultant, and its affiliates, greater compensation.

The Retiree and the Illiquid, Mis-valued Non-Publicly Traded REIT. Another prospective client approached me. Age 68, she was advised by her broker to place all $800,000 of her savings and investments (held in both IRA and non-IRA accounts) into non-publicly traded REITs (all with the same REIT sponsor). I grew suspect. Aside from obvious lack of portfolio diversification this strategy entailed, her statements still reflected a $11 per share price for the REIT shares - the same as the original offering price a few years before. Yet, during this time commercial real estate prices had fallen substantially. Moreover, there was a 10% commission paid to the broker by the REIT upon the sale of this product, in addition to "marketing reimbursements" paid to the broker-dealer firm. It was obvious that the REIT shares were not valued correctly on the brokerage statements. My due diligence uncovered other problems with the REIT. (See this article.) Shortly thereafter, FINRA required the REIT to restate their per share valuations. Later the brokerage firm was fined. Why did the broker sell such an illiquid investment, when many other investments (including publicly traded REITs) were available? To generate higher commissions and fees. Plain and simple.

The Call Center Employee, the Inappropriate IRA Rollover, and the New Retiree. A gentleman, upon his retirement, called the "retirement consultant" to his current 401(k) plan (a large mutual fund complex), seeking guidance on how to commence distributions from the 401(k) plan. The call center employee "advised" the gentleman to roll over his 401(k) plan into an IRA with the same mutual fund complex. The call center employee also "recommended" an asset allocation, including specific funds. Only problem was, the retiree could have stayed in the plan and received the same asset allocation at far lower cost, using the "institutional shares," rather than the higher-fee "retail shares."

Additionally, the retiree had some employer stock in his 401(k) and no advice was provided on the potential to save a substantial amount in taxes. The employer stock had been rolled over into the IRA (and then sold therein) without any consideration given to the Net Unrealized Appreciation (NUA) strategy.

Also, the new retiree was age 57; under the 401(k) plan he could take distributions without early retirement penalties (as the plan offered this provision, which is available under §72(t)(2)(A)(v) of the Internal Revenue Code. Now this gentlemen approached me, to assist him to get money out of his IRA. To avoid the pre-age 59.5 penalty, we set up substantially equal periodic payments. But this was much less flexible than what had existed under the 401(k) plan.

There are major planning issues present when a rollover from a 401(k) to an IRA takes place. See Section XI of my DOL comment letter.

But, simply put, the call center employee was only trained to encourage IRA rollovers - into more expensive mutual funds at that. The advice provided was not as a "fiduciary" - it was neither expert nor done under a duty of due care. Why was this advice given? Simple - it paid the for-profit mutual fund company more money.

The Retiree, the IRA, and the Variable Annuity. A couple came to me, perplexed. They had invested their IRAs in variable annuities, some ten years before. Despite their relatively even allocation between stock funds and bond funds in the various sub-accounts they were advised to invest in, and despite a substantial increase in the stock market over the past five years, their variable annuity's value had only gone up a little. I reviewed the contract. Not surprising, with the riders attached, the variable annuities had total annual fees and costs well in excess of 4% annually.

The clients were perplexed. What about the 7% "guarantee" they had been promised. I explained that this guaranteed rate of return was only effective if they annualized the annuity. But, if they did that, the annuitization rate offered in the variable annuity contract was far below that which was available today.

Why had their broker recommended this variable annuity, rather than mutual funds which were far less costly? Probably because this variable annuity did not mandate any break-point discounts (which reduces the commission charges). (Many variable annuities still don't do this, creating a perverse incentive for brokers to recommend variable annuities rather than mutual funds, to avoid lower commissions.)

Under a proper due diligence analysis, this variable annuity was inappropriate for their IRA accounts. So why had it been recommended? Simple - it resulted in higher commissions to the broker and the brokerage firm.

Economic incentives matter, and they matter a great deal. When a salesperson has the opportunity to receive much higher compensation from the sale of one product, compared to another, the allure of the investment product with the higher compensation (and higher fees to the client) nearly always win.
These insidious conflicts of interest cause great harm to the financial and retirement security of our fellow Americans. The academic research in this area is compelling – higher-cost investments lead, on average, to lower returns. In fact, there is a strong negative correlation between the total fees and costs of an investment product and the returns of that product over the long term, relative to similar investments.

Conflicts of Interest Lead to Poor Investment Recommendations. Conflicts of interest are insidious. The incentivize bad advice to be given.

Disclosures of conflicts of interest are insufficient to protect investors. Indeed, disclosures may actually cause even worse advice to be given. According to Prof. Dalian Cain, Yale School of Management, in “The Dirt on Coming Clean: The Perverse Effects of Disclosing Conflicts of Interest,” “Conflicts of interest can lead experts to give biased and corrupt advice. Although disclosure is often proposed as a potential solution to these problems, we show that it can have perverse effects. First, people generally do not discount advice from biased advisors as much as they should, even when advisors’ conflicts of interest are disclosed. Second, disclosure can increase the bias in advice because it leads advisors to feel morally licensed and strategically encouraged to exaggerate their advice even further. As a result, disclosure may fail to solve the problems created by conflicts of interest and may sometimes even make matters worse.”

The Necessity of the Fiduciary Standard for Providers of Investment Advice. Fiduciary duties are imposed by law when public policy encourages specialization in particular services, such as investment management or law, in recognition of the value such services provide to our society.  For example, the provision of investment consulting services under fiduciary duties of loyalty and due care encourages participation by investors in our capital markets system. Hence, in order to promote public policy goals, the law requires the imposition of fiduciary status upon the party in the dominant position. Through the imposition of such fiduciary status the client is thereby afforded various protections. These protections serve to reduce the risks to the client that relate to the service, and encourage the client to utilize the service. Accordingly, the imposition of fiduciary status thereby furthers the public interest.

Some might opine that financial literacy efforts can fulfill this role. Yet, the body of academic research, and my own experience in dealing with thousands of clients, reveals that financial literacy efforts only significantly assist consumers with basic personal finance training, such as in expenditures budgeting and saving for future needs. However, the complexity of the financial markets, and the limits of time each consumer possesses to devote to training in finance, renders the vast majority of consumers unable to become investment experts or to understand the many terms and concepts required, even with the aid of a multitude of disclosures. We are just as likely to turn a consumer of financial services into a highly knowledgeable designer and manager of her or his investment portfolio as we are to turn a patient needing a brain operation into a neurosurgeon. 

We must recognize that the combination of specialization and interdependence found today is essential to the progress of our society. This combination fosters both the development of new knowledge and expertise. It provides great benefits to consumers, provided the advice is delivered with a high degree of due care and in the consumers’ best interests. It enables consumers to place the fruits of their hard-earned labor to work in the capital markets, with the expectation that the returns offered by the markets will be returned to the consumer, less a reasonable amount for professional-level compensation to the specialist.

America Itself Needs the Fiduciary Standard, to Promote U.S. Economic Growth. In my nearly 30 years as an estate planning and tax attorney, and in my nearly 15 years as a fiduciary investment adviser, I have possessed the opportunity to review hundreds of clients’ investment portfolios. When the clients’ investment portfolios were advised upon by either broker-dealer firms, by dual registrants (firms and individuals with both securities broker/dealer licensure and registered investment adviser licensure), or by insurance agents, the allure of high-fee investment and insurance products was nearly always too strong to resist. Over 95% of the time, in my reviews of hundreds of clients’ portfolios, I discerned high-cost investments, tax-inefficient portfolios, or both.

The high costs of Wall Street’s services and products not only engender the retirement security of individual Americans, but also impair the American economy. As the role of finance has grown ever larger, instead of providing the oil that ensures the American economic engine churns efficiently, the peddling of expensive investment products to Americans has led to a sludge that impairs the vitality and threatens the future of not only our fellow Americans, but Americans itself.

The growth of the financial services industry has grown to an extraordinary proportion of the overall U.S. economy. As stated in a recent article by Gautam Mukunda appearing in the Harvard Business Review: "In 1970 the finance and insurance industries accounted for 4.2% of U.S. GDP, up from 2.8% in 1950. By 2012 they represented 6.6%. The story with profits is similar: In 1970 the profits of the finance and insurance industries were equal to 24% of the profits of all other sectors combined. In 2013 that number had grown to 37%, despite the after effects of the financial crisis. These figures actually understate finance’s true dominance, because many nonfinancial firms have important financial units. The assets of such units began to increase sharply in the early 1980s. By 2000 they were as large as or larger than nonfinancial corporations’ tangible assets …. " Gautam Mukunda, “The Price of Wall Street’s Power,” Harvard Business Review (June 2014).

The result of this excessive rent extraction by Wall Street is impairment of the growth of the U.S. economy. As Steve Denning recently noted in Forbes:
The excessive financialization of the U.S. economy reduces GDP growth by 2% every year, according to a new study by International Monetary Fund. That’s a massive drag on the economy–some $320 billion per year. Wall Street has thus become, not just a moral problem with rampant illegality and outlandish compensation of executives and traders: Wall Street is a macro-economic problem of the first order … Throughout history, periods of excessive financialization have coincided with periods of national economic setbacks, such as Spain in the 14th century, The Netherlands in the late 18th century and Britain in the late 19th and early 20th centuries. The focus by elites on “making money out of money” rather than making real goods and services has led to wealth for the few, and overall national economic decline. ‘In a financialized economy, the financial tail is wagging the economic dog.’
Steve Denning, “Wall Street Costs The Economy 2% Of GDP Each Year,” Forbes (May 31, 2015).  
Wall Street’s lack of legal and ethical constraints have been opined by many as the root cause of the financial crisis of 2008-9 and the resulting recession in the United States, from which we still have not fully recovered. As Jack Bogle, founder of Vanguard, observed: “Self-interest, unchecked, is a powerful force, but a force that, if it is to protect the interests of the community of all of our citizens, must ultimately be checked by society. The recent crisis—which has been called ‘a crisis of ethic proportions’ – makes it clear how serious that damage can become.” John Bogle, “The Fiduciary Principle,” (June 22, 2009), adopted from a speech given to the Columbia University School of Business, New York City, NY, April 1, 2009.
Wall Street's large broker-dealer firms, and the insurance companies, are currently contributing tens of millions (if not hundreds of millions) of dollars to attempt to get the U.S. Congress to stop the DOL's efforts to protect plan sponsors (employers), individual Americans, and to restore U.S. economic growth. Literally, each week dozens of their lobbyists descend upon Capitol Hill. National television ads, of a very deceptive nature, have been expensively produced and now run.
Again and again, I hear ... those who advocate for the fiduciary standard of conduct, and the reduction of conflicts of interest that so pervade are simply outgunned.
BUT ... each of us can help. Please contact your U.S. Representative and U.S. Senators today. Tell them you support the DOL's Conflict of Interest Rule, and that Congress should NOT intervene, at the behest of Wall Street and the insurance companies. Tell them the DOL rule to substantially reduce the conflicts of interest in financial services is right for plan sponsors, right for individual Americans, and right for America itself.
Call, fax or e-mail your U.S. Representative and U.S. Senators today. Get your colleagues, friends, family members, and clients to also contact them. TODAY. Because tomorrow may be too late.
For more information, please visit Save Our Retirement.
Thank you. - Ron


  1. I didn't understand your point, "A CALL TO ACTION" can you explain this to me?? Otherwise it's great article who need financial advise.!!

  2. Excellent rundown, Ron. However, for many fiduciary advisers that provide AUM services, a very strong conflict of interest still exists.These "fiducairies" still have a strong incentive to convince consumers to do transactions that may benefit them more than the consumer.

  3. This comment has been removed by a blog administrator.


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